Thursday, June 1, 2017

Housing: Part 233 - Is the Housing Bubble meme just one big Gish Gallop?

There is one irrefutable fact that we can all agree is true: Home prices were very high in parts of the US in the 2000s, and continue to be high in some cities, as well as in parts of several other developed economies.

We can ask the question, is this because of supply side factors (limited access to valuable real estate) or demand side factors (tax benefits to homeowners, loose monetary policy, frothy mortgage markets, speculative frenzy, etc.) This is what is so odd about public consensus on this topic. We have never really asked this question. Yet, the supply side problem is embedded in all of the demand side explanations about housing bubbles. I don't think there is any disagreement that for those demand side factors to cause a bubble, there has to be inelastic supply. So, the supply side explanation for housing bubbles is imbedded in the demand side explanations, and then everyone goes galloping off with demand side explanations, as if those are the important factors. The premise has been predetermined and the conclusion arises entirely from the premise. This is begging the question.

Isn't it strange that there isn't any particular homogeneity in the demand side factors among the various places with housing price concerns? Fixed versus adjustable rates, long term amortization versus short term with balloon payments, different central banks, public guarantee programs versus private markets, recourse versus non-recourse loans, etc. So, in the US, Canada, Australia, UK, France, etc., a consensus builds around whatever the local set of demand side factors is, and blames those for the "bubble", even though they are different in every location. Of course, those dastardly foreign buyers are always a demand-side factor.

The bias here is extreme. The Financial Crisis Inquiry Report by the federal commission on the causes of the financial crisis (the FCIC) is a great example of this. It's a great summary of the boom and bust. There is a lot of information in there, presented well. Yet, it simply treats the issue as a problem of excessive lending and speculation, a priori. As far as I can tell, limits to urban housing supply are mentioned once, briefly, in one of the dissents at the back of the report.

Now, even if one insists on focusing on the demand side and on the brief spike in prices in the Contagion cities, where the argument for an unsustainable bubble is strongest, at the center of that story are millions of Closed Access housing refugees flooding out of the Closed Access cities and into the Contagion cities. A lack of urban housing is the core causal factor even in the Contagion bubble. The report makes no mention of this.

What we get, instead, is just a litany of anecdotes and descriptions of lending and speculating activities, with various amounts of recklessness or fraud, and it is simply assumed that these anecdotes add up to foundational causation. The report is similar to many of the popular books about the crisis, which are collections of narratives about the various players and agents in the crisis. These books treat every action from developments with the GSEs a half century ago to the last desperate CDO packages in 2007 as "another brick in the wall". The table of contents of these books look something like this:

"A Report on the Failed Harvest"
Chapter 1: Witches Throughout History
Chapter 2: Recent Carelessness about Witches in Our Midst
Chapter 3: Why the Gods are Angry with Local Dissidents
Chapter 4: What the Heretics Have Wrought for All of Us

One assumption at the heart of this bias is that debt can largely be described as a tool for leverage, so that increased use of debt is a sign of recklessness. As with so many issues in finance, this conventional treatment turns reality 180 degrees on its head. It is true that a buildup of debt creates systemic risk. But, debt builds up because debt buyers are seeking safety. Banks aren't leveraged because of demand for high risk capital. They are leveraged because there are trillions of dollars worth of cash that demand risk free low returns in the form of deposits. It wasn't demand for the residual piece of private securitizations that drove that market. It was demand for AAA securities.

We can see this clearly in industries that do not have capital regulations. The relationship between risk and leverage is quite clear. The most leveraged firms are the safest firms - like regulated utilities. They don't issue debt because equity buyers invest in utilities looking for risk. They issue debt because they are in a position to offer debt with very low risk, and the demand for that is great enough that they can earn profits by being a source of fixed income for low risk investors while their equity continues to be fairly low risk. This seems obvious to me. The difference between how debt arises in private markets and how leverage is described in our conventional macro-level narratives is stark.

A small example of this broad sense of question begging is in the FCIC report, on pages 9-10.

One of the first places to see the bad lending practices envelop an entire market
was Cleveland, Ohio. From 1989 to 1999, home prices in Cleveland rose 66%, climbing
from a median of 75,200 to 125,100, while home prices nationally rose about
49% in those same years; at the same time, the city’s unemployment rate, ranging from 5.8% in 1990 to 4.2% in 1999, more or less tracked the broader U.S. pattern.
James Rokakis, the longtime county treasurer of Cuyahoga County, where Cleveland
is located, told the Commission that the region’s housing market was juiced by “flipping
on mega-steroids,” with rings of real estate agents, appraisers, and loan originators
earning fees on each transaction and feeding the securitized loans to Wall Street.
City officials began to hear reports that these activities were being propelled by new
kinds of nontraditional loans that enabled investors to buy properties with little or no
money down and gave homeowners the ability to refinance their houses, regardless
of whether they could afford to repay the loans. Foreclosures shot up in Cuyahoga
County from 3,500 a year in 1995 to 7,000 a year in 2000. Rokakis and other public
officials watched as families who had lived for years in modest residences lost their
homes. After they were gone, many homes were ultimately abandoned, vandalized,
and then stripped bare, as scavengers ripped away their copper pipes and aluminum
siding to sell for scrap.

Pretty damning stuff, huh. Same ol', same ol'. Of course an economy filled with this sort of predation is asking for comeuppance, right?

Here is a graph of home prices among cities that aren't Closed Access or Contagion cities, compared to Cleveland. Cleveland is the thick black line.

You could use the index for Cleveland home prices from 1989 to 2005 as a straight edge. It is difficult to find a single major housing market that was more subdued during this period than Cleveland. This is exactly the effect we should expect from demand side factors where supply isn't a problem - "flipping on mega-steroids" as the report describes it.

Think about it. Take any stochastic market that might be described as a random walk in various ways. Look at the history of that market. There will be times where prices or quantities will be higher or lower, lending will be looser or tighter, foreclosures will be higher or lower. The way this issue is treated, all of those markets are taken as evidence of the predetermined premise and conclusion.

See? In this random market, there was a point in time where there were more foreclosures than there had been at another point in time! Ergo, changing foreclosures caused the thing we are concerned about.

But, shouldn't the fact that nothing happened in Cleveland regarding price levels mean that this example is a mitigating piece of evidence? It would be if we were actually engaged in a review of the evidence. But, we are not. The commission is simply galloping through a set of anecdotes in defense of our priors.